Chapter 19
ANSWERS TO QUESTIONS
1. If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting
open market operation to sterilize the intervention, what will be the impact on international
reserves, the money supply, and the exchange rate?
The purchase of dollars involves a sale of foreign assets which means that both international
reserves and the monetary base decline equally, and thus the money supply decreases.
2. If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the
intervention, what will be the impact on international reserves, the money supply, and the
exchange rate?
The purchase of dollars involves a sale of foreign assets, which means that international
reserves fall and the monetary base decreases. The resulting fall in the money supply causes
3. For each of the following, identify in which part of the balance-of-payments account the
transaction is recorded (current account, capital account, or net change in international
reserves) and whether it is a receipt or a payment.
a. A British subject’s purchase of a share of Johnson & Johnson stock
A receipt in the capital account.
b. An American citizen’s purchase of an airline ticket from Air France
A payment in the current account.
4. Suppose that you travel to Cali (Colombia), where the exchange rate is 1 USD to 2,900
Colombian pesos. As you enter a McDonald’s restaurant, you realize you need 17,400
Colombian pesos to buy a Big Mac. Assuming a Big Mac sells for $5 in the United States,
would you say that the Colombian peso is over- or undervalued in terms of PPP?
Since the exchange rate is 1 USD to 2,900 COP (Colombian Pesos), a Big Mac should sell
5. Refer to the previous exercise. Which type of foreign market intervention must the central
bank of Colombia conduct to keep the exchange rate at a level where the currency is not
under- or overvalued in terms of PPP?
To eliminate the overvaluation in terms of PPP, the exchange rate for the Columbian peso
needs to decline. The central bank of Colombia should undertake an unsterilized foreign
6. What would be the effect of a devaluation on a country’s imports and exports? If a country
imports most of the goods included in the basket of goods and services used to calculate the
CPI, what do you think the effect will be on this country’s inflation rate?
When a country devalues its currency, the fixed exchange rate is set at a lower level, meaning
that the central bank will no longer exchange domestic currency at the previous (higher)
exchange rate. This means that foreigners with the same amount of foreign currency can get
7. Under the gold standard, if Britain became more productive relative to the United States,
what would happen to the money supply in the two countries? Why would the changes in the
money supply help preserve a fixed exchange rate between the United States and Britain?
The increase in British productivity would create a tendency for the pound to appreciate
relative to the dollar. The higher value of the pound would now cause Americans to exchange
dollars for gold, ship the gold to Britain, and then buy British pounds with the gold. The result
8. What is the exchange rate between dollars and Swiss francs if one dollar is convertible into
1/40 ounce of gold and one Swiss franc is convertible into 1/25 ounce of gold?
0.63 francs per dollar.
9. “Inflation is not possible under the gold standard.” Is this statement true, false, or
uncertain? Explain your answer.
False. Inflation occurred when the world was under the gold standard before World War I.
10. What are some of the disadvantages of China’s pegging the yuan to the dollar?
There are several disadvantages to China’s exchange rate strategy. First, diversification is a
problem in that the Chinese own a very large amount of U.S. assets, including low-yielding
11. If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange
rate regime, what kind of intervention would that country’s central bank be forced to
undertake, and what effect would the intervention have on the country’s international reserves
and money supply?
The situation would be as depicted in Figure 2, Panel (b). The central bank would need to sell
domestic currency and buy foreign assets, thus increasing its international reserves and the
12. “The abandonment of fixed exchange rates after 1973 has meant that countries have pursued
more independent monetary policies.” Is this statement true, false, or uncertain? Explain
your answer.
Uncertain. Although after 1973 countries have agreed to no longer intervene in the foreign
exchange market to keep their currencies at par level, and should pursue more independent
13. “If a country wants to keep its exchange rate from changing, it must give up some control
over its monetary policy.” Is this statement true, false, or uncertain? Explain your answer.
True, because when the exchange rate is falling, the central bank must buy its currency,
which lowers its holdings of international reserves and its monetary base. Similarly, when
14. Why is it that in a pure, flexible exchange rate system, the foreign exchange market has no
direct effect on the money supply? Does this mean that the foreign exchange market has no
effect on monetary policy?
There are no direct effects on the money supply, because there is no central bank intervention
in a pure flexible exchange rate regime; therefore, changes in international reserves that affect
15. Why did the exchange-rate peg lead to difficulties for the countries in the ERM after the
German reunification?
German reunification produced tight monetary policy in Germany to limit inflation, which
16. How can exchange-rate targets lead to a speculative attack on a currency?
With a pegged exchange rate, speculators are sometimes presented with a one-way bet in which
the only direction for a currency to go is down in value when a country’s central bank is
17. What are the advantages and disadvantages of having the IMF as an international lender of
last resort?
Central banks in emerging market countries may have limited ability to act as a lender of last
resort since domestic liquidity provisions might lead to higher inflation expectations, and a
18. How can the long-term bond market help reduce the time-inconsistency problem for
monetary policy? Can the foreign exchange market also perform this role?
The long-term bond market can help reduce the time-inconsistency problem because
politicians and central banks will realize that pursuing an overly expansionary policy will
19. “Balance-of-payments deficits always cause a country to lose international reserves.” Is this
statement true, false, or uncertain? Explain your answer.
20. What are the key advantages of exchange-rate targeting as a monetary policy strategy?
First, the exchange-rate target directly keeps inflation under control by tying the inflation rate
21. When is exchange-rate targeting likely to be a sensible strategy for industrialized countries?
When is exchange-rate targeting likely to be a sensible strategy for emerging market
countries?
Exchange rate targeting is likely to be a sensible strategy for industrialized countries when
22. What are the advantages and disadvantages of currency boards and dollarization over a
monetary policy that uses only an exchange-rate target?
The implicit exchange rate is 25 USD to 948.25 THB, or 1 USD to 37.93 THB. Using the
ASWERS TO APPLIED PROBLEMS
23. Suppose the Federal Reserve purchases $1,000,000 worth of foreign assets.
a. If the Federal Reserve purchases the foreign assets with $1,000,000 in currency, show
the effect of this open market operation, using T-accounts. What happens to the monetary
base?
The Fed’s assets increase by $1 million, and it increases currency in circulation by $1
million. This results in the monetary base increasing by $1 million.
Federal Reserve System
Assets
Liabilities
Foreign assets
+$1 million
Currency in circulation
+$1 million
b. If the Federal Reserve purchases the foreign assets by selling $1,000,000 in T-bills, show
the effect of this open market operation, using T-accounts. What happens to the monetary
base?
Federal Reserve System
Assets
Liabilities
Foreign assets
+$1 million
Currency in circulation
24. Suppose the Mexican central bank chooses to peg the peso to the U.S. dollar and commits to
a fixed peso/dollar exchange rate. Use a graph of the market for peso assets (foreign
exchange) to show and explain how the peg must be maintained if a shock in the U.S.
economy forces the Fed to pursue contractionary monetary policy. What does this say about
the ability of central banks to address domestic economic problems while maintaining a
pegged exchange rate?
An increase in U.S. interest rates as a result of the contractionary monetary policy will
increase the demand for dollar assets and reduce the demand for peso assets from D1 to D2,
which will appreciate the dollar and depreciate the peso. This results in the peso being valued
below the peg; in order to maintain the peg, the Mexican central bank must increase domestic
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database, and find data on net exports
(NETEXP), transfers, (A123RC1Q027SBEA) and the current account balance (NETFI).
a. Calculate net investment income for the most recent quarter available, and for the same
quarter a year earlier.
b. Calculate the percentage change in the current account balance from the same quarter
one year earlier. Which one of the three items making up the current account balance
had the largest effect in percentage terms on the change of the current account? Which
one had the smallest effect?
In percentage terms, the current account balance declined by less than one percent
Current
Account
Balance
($Bil.)
Transfers
Net
Exports
Net
Investment
Income
2. Go to the St. Louis Federal Reserve FRED database and find data on the monthly U.S. dollar
exchange rate to the Chinese yuan (EXCHUS), the Canadian dollar (EXCAUS), and the
South Korean won (EXKOUS). Download the data into a spreadsheet.
a. For the most recent five-year period of data available, use the average, max, min, and
stdev functions in Excel to calculate the average, highest, and lowest exchange rate
values, as well as the standard deviation of the exchange rate to the dollar (this is an
absolute measure of the volatility of the exchange rate).
a. See table below for July 2012 to July 2017.
South
Korean Won
Chinese
Yuan
Canadian Dollar
Average
1113.04
6.37
1.18
Maximum
1216.23
6.92
1.42
Minimum
1018.74
6.05
0.98
Standard Deviation
0.26
0.14
Max Min Difference/Average
0.14
0.37
SD/Average
0.04
0.12
b. (b) See table above. The Chinese yuan has a much smaller band that it moves in
relative to the average value; at only 14% of the average, this is slightly smaller than
the South Korean Won, and more than half as much as the Canadian dollar bands that
they fluctuated in over the last five years. Hence the Chinese yuan is the most likely
to be pegged.